andytrader

Which of the following best describes the difference between spread duration and portfolio duration? Spread duration allows the manager to measure the sensitivity of portfolio value from changes in:

A) both convexity and yield changes.

B) the price of the underlying securities.

C) yield levels relative to a benchmark yield.

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With duration a parallel shift in the yield curve could be caused by a change in inflation expectations which causes the yields on all bonds, including treasuries, to increase/decrease the same amount. In spread duration, the shift is in the spread only, indicating an overall increase in risk aversion (risk premium) for all bonds in a given class.

andytrader

Two portfolios have the same portfolio duration but one of them has a higher nominal spread duration. How does the higher spread duration affect the portfolio characteristics? The higher spread duration portfolio will have:

A) the same exposure to small parallel shifts in the Treasury curve but will have a higher exposure to changes in the yield difference between non-Treasury and Treasury bonds.

B) the same exposure to small parallel shifts in the Treasury curve but will have a higher exposure to changes in the yield difference between long and short-term Treasury securities.

C) a higher exposure to small parallel shifts in the Treasury curve and a higher exposure to changes in the yield difference between non-Treasury and Treasury bonds.

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Nominal spread is the spread between the nominal yield on a non-Treasury bond and a Treasury of the same maturity.

andytrader

If interest rates rise sufficiently such that the dollar safety margin is negative in a contingent immunization strategy, which of the following statements is least accurate?

A) Contingent immunization is still a viable alternative.

B) The portfolio manager can no longer use contingent immunization.

C) A switch to immunization is necessary.

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If the dollar safety margin is negative, the present value of liabilities exceeds the present value of assets and the portfolio manager can no longer use contingent immunization. Equivalently, the portfolio manager must switch to immunization.

andytrader

A portfolio manager has decided to pursue a contingent immunization strategy over a four-year time horizon. He just purchased at par $26 million worth of 6% semiannual coupon, 8-year bonds. Current rates of return for immunized strategies are 6% and the portfolio manager is willing to accept a return of 5%. Given that the required terminal value is $31,678,475, and if the immunized rates rise to 7% immediately, which of the following is most accurate? The dollar safety margin is:

A) positive ($370,765) and the portfolio manager can continue with contingent immunization.

B) negative (-$1,423,980) and the portfolio manager must switch to immunization.

C) positive ($6,158,602) and the portfolio manager can continue with contingent immunization.

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We are given the required terminal value of $31,678,475.
Next, we calculate the current value of the bond portfolio: PMT = ($26,000,000)(0.03) = $780,000; N = 16; I/Y = 7/2 = 3.5%; and FV = $26,000,000; CPT → PV = $24,427,765.
Next, compute the present value of the required terminal value at the new interest rate: FV = $31,678,475; PMT = 0; N = 8; I/Y = 7/2 = 3.5%; CPT → PV = $24,057,000.
Alternatively $31,678,475 / (1.035)8 = $24,057,000
The dollar safety margin is positive ($24,427,765 − $24,057,000 = $370,765) and the manager can continue to employ contingent immunization.

andytrader

A portfolio manager has decided to pursue a contingent immunization strategy over a three-year time horizon. He just purchased at par $93 million worth of 10.0% semiannual coupon, 12-year bonds. Current rates of return for immunized strategies are 10.0% and the portfolio manager is willing to accept a return of 8.5%. If interest rates rise to 11% immediately, which of the following statements is most accurate? The dollar safety margin is:

A) positive ($303,066) and the portfolio manager can continue with contingent immunization.

B) negative (-$2,489,748) and the portfolio manager must switch to immunization.

C) positive ($303,066) and the portfolio manager must switch to immunization.

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We must first compute the required terminal value: PV=$93,000,000, N=6, I/Y=8.5/2=4.25%, PMT=0, compute FV=$119,382,132. Next, we calculate the current value of the bond portfolio: PMT=($93,000,000)(.05)=$4,650,000, N=24, I/Y=11/2=5.5%, and FV=$93,000,000, CPT → PV=$86,884,460. Next, compute the present value of the required terminal value at the new interest rate: FV=$119,382,132, PMT=0, N=6, I/Y=11/2=5.5%, CPT → PV=$86,581,394.
Alternatively ($119,382,132) / (1.055)6 = $86,581,394
The dollar safety margin is positive ($86,884,460 − $86,581,394 = $303,066) and the manager can continue to employ contingent immunization.

andytrader

Which of the following is NOT a key consideration in implementing a contingent immunization strategy?

A) Identifying a suitable and immunizable safety net.

B) Decide in advance about the frequency the portfolio will be rebalanced.

C) Establishing well defined immunized initial and ongoing available target returns.

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The frequency of rebalancing is determined (among other things) by the level of the safety net. So the rebalancing frequency is not exogenous to interest rate movements.

andytrader

In a contingent immunization strategy, which of the following is a reason why the minimum target return might NOT be realized? The minimum target return might not be realized because:

A) interest rates move in a nonparallel manner.

B) there is a rapid market yield movement.

C) the yield volatility changes.

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A rapid market yield movement might not give the manager enough time to shift from an active strategy to immunization mode to achieve the minimum target.

andytrader

A portfolio manager has decided to pursue a contingent immunization strategy over a three-year time horizon. She just purchased at par $84 million worth of 9.2% semi-annual coupon, 10-year bonds. Current rates of return for immunized strategies are 9.2% and the portfolio manager is willing to accept a return of 8.5%. Given that the required terminal value is $107,829,022, and if interest rates rise to 11% immediately, which of the following is most accurate? The dollar safety margin is:

A) negative (-$3,237,038) and the manager can continue with contingent immunization.

B) negative (-$3,237,038) and the manager must switch to immunization.

C) positive ($1,486,948) and the manager can continue with contingent immunization.

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We are given the required terminal value of $107,829,022. Next, we calculate the current value of the bond portfolio: PMT=($84,000,000)(.046)=$3,864,000, N=20, I/Y=11/2=5.5%, and FV=$84,000,000, CPT → PV=$74,965,511. Next, compute the present value of the required terminal value at the new interest rate: FV=$107,829,022, PMT=0, N=6, I/Y=11/2=5.5%, CPT → PV=$78,202,549. Alternatively ($107,829,022) / (1.055)6 = $78,202,548 The dollar safety margin is negative ($74,965,511 − $78,202,549 = -3,237,038) and the manager can no longer employ contingent immunization.
Therefore, a switch to immunization is necessary.

andytrader

John Gillian approaches Carl Mueller, CFA, about managing his bond portfolio. Gillian has two large bond positions. The first of these is $2.8 million face value with a coupon rate of 7.6% (paid semiannually), ten years to maturity, and is currently priced to yield 6.5%. The second position is $4.4 million face of zero coupon bonds that will mature in four years and are priced to yield 5.3%. Gillian asks about interest rate forecasts for the next four years. Mueller says that he expects yields to remain approximately the same (i.e. 6.5%) for maturities of six to 10 years. Gillian says that he needs to have at least $8 million in value at the end of four years.
After further discussion with Gillian about his goals, Mueller determines that a contingent immunization strategy would be the best approach for the coupon-bond position. Gillian asks Mueller to explain the strategy. Mueller says that it is a fairly simple strategy that has only two requirements: determining an available target return and an appropriate safety net return.
Mueller begins computing the necessary inputs for the coupon-bond position. He first calculates the required terminal value and associated target return. Given Gillian’s goal for the total portfolio value, Mueller computes the safety net return, cushion spread, and dollar safety margin.
Gillian asks how likely it is that Mueller will have to immunize the portfolio. He asks if Mueller’s immunization strategy would be required if there is a 50 basis point increase in the market yield today and the rates remain at that level for the next four years.Mueller’s description of the requirements of a contingent immunization strategy is:

A) correct.

B) incorrect because the strategy does not require an available target return although it does require an appropriate safety net return.

C) incorrect because it is incomplete.

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The strategy does require both an available target return and an appropriate safety net return. Mueller did not mention an important third step: the establishment of effective monitoring procedures to ensure adherence to the contingent immunization plan. (Study Session 9, LOS 23.i)

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The most likely reason that Mueller did not discuss an immunization strategy for Gillian’s zero-coupon bond position is:

A) there was no need to do so.

B) it is possible to immunize zero coupon bonds, but it is very costly.

C) it is impossible to immunize zero coupon bonds.

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Since the maturity of the zero coupon bonds coincided with the investment horizon, there was no need to immunize that position. There is neither reinvestment nor price risk. (Study Session 9, LOS 23.k)

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The required terminal value for the coupon-bond position is:

A) $4.43 million.

B) $3.4 million.

C) $3.6 million.

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Since Gillian requires a total of $8 million for his portfolio and the zero coupon bonds will mature with a value of $4.4 million, the coupon bonds have a required terminal value equal to $8 million minus $4.4 million, or $3.6 million. (Study Session 9, LOS 23.i)

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The cushion spread for the coupon-bond position is:

A) 2.09%.

B) 2.20%.

C) 2.04%.

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Cushion spread is the difference between current rates of return and the minimum required rate of return:
The current value of the coupon bond position is:
INPUTS: N= 20, I/Y = 6.5%/2 = 3.25%, PMT = 7.6%/2 = 3.8% of $2.8 million = $106,400, FV = 2,800,000,  CPT PV → PV = -3,023,906 (ignore minus sign)
The minimum required return based upon the required terminal coupon-bond position value of $3.6 million and its present value is (3,023,906)(1+X)8 = 3,600,000.  Solving for X we then have:
(1+X)8 = 3,600,000 / 3,023,906
(1+X)8 = 1.1905
1+X = 1.1905.125
1+X = 1.02204
X = .02204
I = 2.204% X 2 = 4.41%
Cushion spread = 6.50 - 4.41 = 2.09%
(Study Session 9, LOS 23.i)

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The dollar safety margin for the coupon-bond position is closest to:

A) $0.226 million.

B) $0.237 million.

C) $0.290 million.

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This is the difference between the current value of the bond portfolio and the present value of the estimated terminal value given the current return:
Current value of the portfolio = $3.024 million as determined in the previous question.
Assets required given a terminal value of $3,600,000 and current rates of return of 6.5%:
3,600,000 / (1.0325)8 = 2,787,289
Dollar safety margin = 3,023,906 - 2,787,289 = 236,617
(Study Session 9, LOS 23.i)

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Given the forecast of a 50 basis point increase in market yield on the coupon bonds, Mueller will:

A) have to switch to an immunization strategy for the portfolio.

B) have to switch to a passive management strategy for the portfolio.

C) be able to continue with an active management strategy for the portfolio.

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For a 50 basis point increase in market yields to 7.0% the present value of assets will then become:N = 20, I/Y = 3.5, PMT = 106,400, FV = 2,800,000, CPT PV → PV = -2,919,384
Assets required at the new interest rate of 7.0% =
3,600,000 / (1.035)8 = 2,733,882
The present value of assets of $2.9 million > present value of assets required of $2.7 million thus a 50 basis point increase in market yields will not trigger a switch to immunization to achieve the terminal value of $3.6 million for the coupon bonds. (Study Session 9, LOS 23.i)

andytrader

Which of the following refers to the risk that floating rate assets may have an upper bound on the interest rate whereby a maximum rate of interest on the asset is achieved?

A) Call risk.

B) Interest rate risk.

C) Cap risk.

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Cap risk is the risk that the interest rate is capped (has a maximum) and that interest income from the asset is then capped.